Understanding the Foreign Exchange Markets Fundamentals

People are generally under the impression that to start trading forex,they need to have considerable capital or funds. However, forex trading experts say that it is, in fact, quite the opposite. People can easily start forex trading without having a lot of funds. But they must have a solid and clear understanding of the fundamentals of this market to sustain themselves profitably.

Yes, certain very basic factors can have tremendous effects on the foreign exchange market. In this post, let us find out the fundamental factors that influence the exchange rates of currencies.

Foreign Exchange Markets Fundamentals
Foreign Exchange Markets Fundamentals
  • Currency strength and trade balance between countries

The import-export or trading activities between nations can impact the exchange rate of the currency. When the total export and import valuations of a nation are unequal, it generates more supply or demand for that particular currency, which decides its value in the foreign exchange market.

While a stronger currency makes more affordable imports, it hampers profits made from exports. On the other hand, a weaker currency makes imports expensive but is great for export activities. That is the reason why net exporters prefer a weak local currency, while net importers earn better profits with a stronger local currency.

  • Intervention by central banks

When the central bank of a nation actively influences the exchange rate of that particular currency, the act is called Foreign Exchange Intervention. This is a kind of monetary policy, which can have transformative effects on the foreign exchange rate of a particular currency. The central banks either leverage their authority ingenerating currency or utilize their reserves to increase the supply of money. Or they can also intervene by using verbal indications. Verbal interventions are usually left open for interpretation as per the exchange rate of the currency. But more often than not, central bank interventions are aimed to stabilize the exchange rate of the currency.

  • Local fiscal policy and inflation targets

The primary aim of the fiscal policy adoptedby the government is to raise the rate of interest. When the interest rates are much higher, it automatically discourages spending among consumers. This ultimately raises the currency exchange rate. In the USA and UK, fiscal policies are the most vital means of maintaining lower inflation rates. The inflation target is set by the government. And an expansionary fiscal policy leads to balancing inflation and interest rates. Higher rates of interest attract foreign investment, which in turn raises the currency exchange rate.

  • Purchasing power parity and the Big Mac index  

Purchasing power parity between countries is a theory that states that in the long term, the currency exchange rates of different countries should move towards equality towards the price of a benchmark. The benchmark here is a McDonald’s Big Mac. The Big Mac Index is a global standard for comparing currency values or local economic purchasing power and is considered to be roughly accurate by some economists. It can offer a fair idea about a nation’s currency exchange rate.

In conclusion

Various other factors also influence the ups and downs of the forex market. But if one understands these fundamental aspects and closely follow world news regularly, they can make profitable decisions in online forex trading.

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